Investors now looking beyond political risk

Before UK prime minister Theresa May surprised markets with a snap general election, 2017 was already the year of political risk for Europe.

Investors now looking beyond political risk

The Netherlands, France, Germany and possibly Italy had all scheduled to go to the polls this year. The rise of populist, anti-European parties in these countries has amplified political risk, altering the traditional political focus for markets, from fiscal prudence to populism and the viability of the whole European project.

Polling data had become an unreliable tool for investors. Markets reacted instantly to the first round result of the French election. A relief rally in equities and peripheral bonds was coupled with the selling of safe-haven, German debt. The concerns over the UK election, Brexit negotiations and Donald’s Trump unpredictable policies are now being passed over, with investors starting to focus on the timing for Europe’s first interest rate hike.

The result of the first round of the French presidential election eased concerns over another populist political upset. After the 2015 UK election, Brexit and Trump, finally the pollsters struck back. Investors now believe the tail risk from a Le Pen victory has all but evaporated. The restoration of confidence in polling data allows investors to position aggressively into the UK election in June and the German election in September.

The anti-European party in Germany, Alternative for Deutschland, has lost momentum in recent weeks. Angela Merkel’s CDU party is expected to battle it out with Martin Schulz, the leader of the SPD, for the role of chancellor, with both candidates market- friendly and pro-European. As investors look beyond political risk, they are starting to look towards interest rate risk.

Interest rates have started rising in the US. The Fed has already increased borrowing rates once this year, with a minimum of two further rate hikes anticipated in the remainder of 2017. The US Fed Funds rate is at 0.75%-1% from a crisis low of 0%-0.25%. The EU has lagged behind the US recovery. However, recent data suggest a turnaround is coming.

Political risk had tempered the improving macro-economic backdrop in the EU. Falling unemployment, stronger growth and rising consumer confidence across Europe has had some calling for the ECB to start to consider the ongoing appropriateness of the its extraordinary policy measures and commence normalisation.

Political risk is set to give way to interest-rate risk as a main concern for European investors. By June, some market participants expect the ECB to give hints as to when the Central Bank will start to rein in stimulus. However, the ECB is committed to buying European sovereign bonds until the end of this year. Purchases are unlikely to stop abruptly with a gradual tapering expected in the first half of 2018. The first EU interest rate hike is expected in late 2018 or early 2019.

We have almost certainly seen European bond yields trade at their lowest levels and as investors to start to look towards the path to rate hikes, yields are set to rise. The equity market reaction to rising interest rates will be more interesting.

Conventional wisdom is that equity markets do not like interest rate hikes, though this has not stopped US equity markets from continually setting record new highs in 2017 and the first half of 2018. Interest rate hikes are a product of an improving economy.

Given the record low interest rates, small hikes will initially have less of an impact on discretionary spending than in a normal rate-hiking cycle. Rates will remain ‘accommodative’ for a long time. The US is showing a slow and shallow rate rise trajectory does not have to dislocate equity markets while facilitating a gradual rise in bond yields. ECB, are you watching? n Ryan McGrath is a senior analyst at Cantor Fitzgerald Ireland

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